CENTER ON JAPANESE ECONOMY AND BUSINESS PROGRAM … · Hedge Fund Investments at the Virginia...
Transcript of CENTER ON JAPANESE ECONOMY AND BUSINESS PROGRAM … · Hedge Fund Investments at the Virginia...
C E N T E R O N J A P A N E S E E C O N O M Y A N D B U S I N E S S
P R O G R A M O N A L T E R N A T I V E I N V E S T M E N T S
I N V E S T I N G I N H E D G E F U N D S A N D P R I VAT E E Q U I T Y :VIEWPOINTS OF U.S. AND JAPANESE INSTITUTIONAL INVESTORS
The Program on Alternative Investments analyzes several major alternative investment asset classes—including
hedge funds, private equity, and real estate—in Japan and elsewhere in East Asia. The Program meets its
substantive goals through a combination of research projects, conferences, symposia, and seminar presenta-
tions under the direction of Dr. Mark Mason. For a schedule of upcoming seminars and other Program activities,
consult the Program’s website at http://www.gsb.columbia.edu/japan/alternatives. Dr. Mason can be contacted
by e-mail at [email protected].
Lead Sponsors: Nomura Securities Co., Ltd.; Daido Life Insurance Company
Continuing its series examining Japanese institutional investments in alternative assets in comparative
perspective, the Program on Alternative Investments at Columbia Business School’s Center on Japanese
Economy and Business organized a symposium titled “Investing in Hedge Funds and Private Equity:
Viewpoints of U.S. and Japanese Institutional Investors.” The event, held in midtown Manhattan on March 31,
2004, attracted a capacity audience of 125 people drawn mainly from the New York academic and practitioner
communities.
The symposium was organized into two panel discussions followed by a keynote address.
The first panel focused on U.S. versus Japanese institutional investments in private equity. Hideya Sadanaga,
Senior Vice President of Nippon Life Insurance Company, and Sheryl Schwartz, Managing Director of TIAA-
CREF, made initial presentations on their respective institutions’ views on and participation in private equity
investing. Kazuo Seki, CEO of AI Capital, and Narv Narvekar, CEO of the Columbia University Investment
Management Company, then offered comments as representatives of a Japanese financial intermediary and a
U.S. university endowment.
The second panel examined investments in hedge funds. Kazuki Nakamoto, Managing Director of Daido Life
Insurance Company, and Lawrence Kochard, Managing Director of the Virginia Retirement System, discussed
participation in hedge funds from the viewpoints of a Japanese life insurance company and a U.S. public
pension fund. Their presentations were followed by comments from Franklin Edwards, Professor of Finance
at Columbia Business School, and Robert Discolo, Managing Director of AIG Global Investment Corporation.
David Russ, Treasurer of the University of California, concluded the symposium with a keynote address out-
lining his views on the overall rationale for alternative investments in an institutional portfolio together with
the specific activities of his institution in this field.
This report covers the presentations and discussion of the panel on hedge funds. Although the private equity
panel and the keynote address proved equally enlightening, the related symposium proceedings were unfor-
tunately lost due to technical difficulties with the recording equipment.
Investing in Hedge Funds
MARK MASON
Director, Program on Alternative
Investments, Center on Japanese
Economy and Business, Columbia
Business School
Our second panel this afternoon
examines U.S. and Japanese institu-
tional investments in hedge funds. As
we all know, the hedge fund industry
is experiencing dramatic growth.
There are now an estimated seven
to eight thousand hedge funds
worldwide, which together manage
perhaps US$800 billion or more in
assets. Many U.S.-based institutions
in addition to family offices and
high-net-worth individuals have
already made substantial commit-
ments to the hedge fund industry,
but only recently have their Japanese
counterparts entered the field in any
substantial way. Although it is likely
that significant numbers of Japanese
institutional investors will continue
to enter into or increase their partici-
pation in the hedge fund industry,
many among them have raised
serious concerns about such invest-
ments, ranging from transparency
and liquidity to capacity, benchmark-
ing, and performance. To consider
the potential risks as well as rewards
of hedge fund investing, we are
joined this afternoon by a distin-
guished panel of speakers from lead-
ing institutions based in both Japan
and the United States. I would like
first to ask Dr. Lawrence Kochard,
Managing Director of Equity and
Hedge Fund Investments at the
Virginia Retirement System, to share
his thoughts with us. The Virginia
Retirement System is a major U.S.
public pension fund, of course, and
Dr. Kochard has academic as well
as practitioner credentials relating
to the hedge fund industry.
LAWRENCE KOCHARD
Managing Director of Equity and
Hedge Fund Investments, Virginia
Retirement System
I span the real world and the aca-
demic world. I manage the equity
group and the hedge fund program
for the Virginia Retirement System,
which is a US$40 billion defined ben-
efit pension fund in Virginia for pub-
lic employees and teachers. Virginia
got involved fairly early with alterna-
tives, investing in private equity in
the late 1980s. This has paid off
nicely, given their entry point. Even
though we have just started our
stand-alone hedge fund program,
we in fact have been investing
with equity market neutral managers
and distressed managers within
our public equity and private equity
programs, so we have also had a lot
of experience with hedge fund-type
managers. We have a board, an
investment committee, and a staff
that is interested in looking at all
alternatives.
Let me start this talk by discussing
the University of Virginia, where I
teach part time. I teach an invest-
ments course every spring. Several
years ago, the University sponsored
a symposium not that different than
this, on hedge funds. Virginia is for-
tunate enough to have a number of
Alternative Investments Report Restructuring Distressed Companies in Japan 32 Center on Japanese Economy and Business Program on Alternative Investments
INVESTING IN HEDGE FUNDS AND PRIVATE EQUITY : VIEWPOINTS OF U.S. AND JAPANESE INSTITUTIONAL INVESTORS
PROGRAM ON ALTERNATIVE INVESTMENTS
Center on Japanese Economy and Business
Columbia Business School
The Lotos Club
Five East 66th Street, New York
Wednesday, March 31, 2004
F U L L A G E N D A
4:00 P.M. WELCOME AND OPENING REMARKS
Mark MasonDirector, Program on Alternative Investments
Center on Japanese Economy and Business
Columbia Business School
4:05 P.M. INVESTING IN PRIVATE EQUITY
Moderator Hugh PatrickR.D. Calkins Professor of International Business
Emeritus
Director, Center on Japanese Economy and
Business
Columbia Business School
Speakers Hideya SadanagaSenior Vice President
Nippon Life Insurance International
Sheryl SchwartzManaging Director
TIAA-CREF
Discussant Narv NarvekarPresident, CEO, and CIO
Columbia Investment Management Company
Commentator Kazuo SekiPresident and CEO
Alternative Investment Capital
5:05 P.M. COFFEE BREAK
5:25 P.M. INVESTING IN HEDGE FUNDS
Moderator Mark Mason
Speakers Lawrence E. KochardManaging Director of Equity and
Hedge Fund Investments
Virginia Retirement System
Kazuki NakamotoManaging Director
Daido Life Insurance Company
Discussant Franklin EdwardsArthur F. Burns Professor of Free and
Competitive Enterprise
Columbia Business School
Commentator Robert DiscoloHead of Hedge Fund Group
AIG Global Investment Corporation
6:25 P.M. KEYNOTE ADDRESS
Moderator Larry GlostenS. Sloan Colt Professor of Banking and
International Finance
Chair of Finance and Economics Division
Columbia Business School
Speaker David RussTreasurer and Vice President for Investments
University of California
6:55 P.M. CLOSING REMARKS
Hugh Patrick
7:00 P.M. COCKTAIL RECEPTION
“Investing in Private Equity” panelists from left to right: Narv Narvekar, Hideya Sadanaga,
Sheryl Schwartz, Kazuo Seki, and Hugh Patrick
“Investing in Hedge Funds” panelists from left to right: Kazuki Nakamoto, Lawrence E. Kochard,
Franklin Edwards, Robert Discolo, and Mark Mason
Now, I have a former student who
did two years in the analyst training
program and left to trade for a large
distressed firm. He is doing very
well. The amount of time it takes to
go from the banking world or the
sales and trading world to the hedge
fund world has been cut down sub-
stantially. This influx of the best and
brightest into hedge funds gets me
interested as an investor. However,
it also attracts a lot of bad people
because the pay is so high. Two years
ago I was speaking at a conference
that was not nearly of the quality of
this conference. I was sitting at lunch
during that conference and I was
asking the gentleman on my right,
“What do you do? Why are you
here?” and he said, “Well, I just sold
my broker-dealer down in West Palm
Beach and I am trying to figure out
my next business and I have heard
these hedge funds are a great way
to make money.” The business will
continue to attract the best, but it is
going to attract the worst, too. That
really raises the bar in trying to deter-
mine who is good and who is not.
The second reason I get excited
about hedge funds compared to the
long-only world is that the managers
eat their own cooking. They are
investing alongside of me. The vast
majority of hedge funds have most
of their liquid net worth invested in
the fund and to me, that is the ulti-
mate risk control. That helps me get
comfortable with some of the lack
of position transparency that exists.
In fact, if there is any kind of trans-
parency I want, it is getting some
kind of read on what is the percent-
age of their wealth that is invested in
the fund. This is the thing that really
distinguishes these types of invest-
ment managers from a lot of other
investors. These are the reasons that
people got interested in hedge funds
—they are high return, lower risk
relative to the public markets. It is
a well-known fact that there is sur-
vivorship bias in the data, and there
is also a reporting bias problem,
where only good funds report to the
databases. The returns are also artifi-
cially smoothed. This was shown in
a study by Cliff Asness, who is a
very good hedge fund manager. This
smoothing produces artificially low
volatility and correlations to other
assets. Another thing to be aware of
is that a manager can produce the
appearance of good returns by going
short volatility, just selling options.
What have all the good return num-
bers done? The result has been a
rapid rise in hedge fund assets as
we discussed before. One hedge
fund expert believes the total capital
invested in hedge funds will increase
to two trillion dollars by the end of
the decade. That is just a guess, but
I do think that there is a broad trend
to increase the allocation to hedge
funds. Public funds still have a small
allocation to hedge funds and express
a lot of skepticism about these man-
agers. It is still an open issue whether
public funds will broadly embrace
hedge funds. Fundamentally, public
funds often conclude that if an asset
class is not a meaningful percentage
of assets, then it is not worth pursu-
ing. I contend that if there is any
source of alpha, it is worthwhile try-
ing to do some of it. If you cannot
find any alpha, then go passive.
One of the biggest challenges for
us is trying to keep and retain good
staff to help manage alternatives,
both hedge fund and private equity
programs. I think that is going to be
one of the natural constraints and
limitations for public funds. I will dis-
cuss this and other hedge fund issues
that are important to us as a public
fund. These issues include perform-
ance, fees, transparency, benchmark-
ing, and fund of funds.
Alternative Investments Report Restructuring Distressed Companies in Japan 5
hedge fund managers who are stars,
which includes a lot of Tiger cubs.
The first panel consisted of Julian
Robertson, John Griffin, Michael Bills,
Paul Tudor Jones, and Lee Ainsley.
It was a tremendous panel, talking
about hedge funds and investing.
They discussed a number of interesting
issues and are clearly very talented
investors. The day concluded with
a presentation from a 24-year-old
University of Virginia alumnus who
had worked at one of the larger
funds and who was starting his own
hedge fund. Even though this fledg-
ling investment manager had no
track record and struggled to articu-
late an investment strategy and
process, he had already raised $25
million of assets. This story relates
to a comment made earlier today,
which articulated a healthy skepti-
cism about all alternatives. One of
the panelists, Narv from Columbia,
was talking about what he expects
from both private equity and hedge
funds in the way of future returns.
I think he expresses a very legitimate
concern. This is largely due to the
amount of money going into this
market. I like to do this when I
teach: I read from the Wall Street
Journal or another investment
publication. This is the most recent
issue of P&I—article one: “Pension
Funds Investment Causes Crunch
in Capacity”; article two: “Luring
Marketers Is Proving Tough to
Managers.” So, they are trying to hire
marketing people—that is not a good
sign from my standpoint, especially
when there is a capacity crunch.
There is just a lot of money going
into this asset class. VRS, as a mid- to
large-size public fund, has US$40 bil-
lion in total assets. Calpers has well
in excess of three times this amount
of money to invest. We are trying to
invest a lot of money. Investments in
hedge funds could never be a sizable
percentage of our assets. However,
there are a lot pensions that are
looking to dip their toes in the water,
so to speak, putting money in hedge
funds. The concern I have, and
one of the reasons all plan sponsors
are looking at these alternatives,
is because we are all somewhat
pessimistic about the markets. A prior
speaker asked “Where is the alpha?
Where is the beta?” Where are
returns going to come from to fund
the pension liabilities that we, and
every other pension around the
world, has. Everyone is looking for
that magical alternative high-return
investment. The fact that so many
people are trying to generate extra
alpha to compensate for the lack of
market returns is what will necessarily
lead to greater market efficiency and
hence lower alpha. This will put a
cap on how much money we can
practically invest in hedge funds. As
my colleague from Columbia said, that
does not mean we should not do it.
There are still, in my mind, very
talented investors out there who are
in the hedge fund world. There are
still talented investors in the private
equity world and it should not stop
us from doing that, but we should
approach this with a healthy degree
of skepticism. Of the half dozen rea-
sons that I have given to my board,
investment committee, and, therefore,
the public, for why VRS is investing
in hedge funds, I would say there are
two I feel strongest about. The first,
a performance incentive-based com-
pensation structure attracts some of
the best investment management tal-
ent in the industry to this business.
Secondly, managers invest a majority
of their own wealth in the funds,
differentiating themselves from tradi-
tional long-only money managers.
The others you probably see in every
other hedge fund presentation: the
fact that hedge funds can generate
returns that have low volatility, low
correlation with other assets,
and that they are able to do things
that are nontraditional, capitalize on
opportunities. These are all true,
but there are two arguments that get
me most excited about hedge funds.
Without a doubt, the talent is gravi-
tating away from the long-only world
to the hedge fund world. I see this
firsthand since I also run the public
equity group where we invest US$26
billion, with the majority of this
money being managed externally.
Why is this occurring? (A) Because
they are making more money;
(B) because it is more interesting;
and (C) because it is less transparent,
and they do not have to deal with
the clients quite as much. It is just
attracting the best and the brightest.
It is also attracting the best and the
brightest from Wall Street. Having
worked at Goldman Sachs years ago,
very few of my former colleagues
are still with the firm. A lot of them
have started hedge funds. Years ago,
someone would work at Goldman
Sachs ten years, maybe twenty years,
and then go off and either start a
hedge fund or private equity firm.
4 Center on Japanese Economy and Business Program on Alternative Investments
Without a doubt, the talent is gravitating away from the long-only
world to the hedge fund world.
—Lawrence Kochard
Lawrence Kochard
if we can generate alpha. Identifying
good managers will become increas-
ingly challenging. Leveraging fund
of funds, consultants, and other
resources is going to be important
for us to do our job effectively.
Finally, being able to retain staff to
manage a hedge fund program will
be an ongoing challenge.
MARK MASON
Thank you, Larry. Our next speaker
is Mr. Kazuki Nakamoto, Managing
Director of Daido Life Insurance.
Mr. Nakamoto has kindly agreed to
enlighten us on Japanese institutional
views toward hedge fund investing.
I should point out that Nakamoto-san
was one of the pioneers—and is now
one of the thought-leaders—in the
Japanese institutional investor com-
munity when it comes to investing in
private equity as well as hedge funds.
KAZUKI NAKAMOTO
Managing Director, Daido Life
Insurance Company
Before going into our hedge fund
investment program, I would like to
spend a few minutes describing our
firm. Daido is the fifth largest life
insurance company in Japan in terms
of premium income, with total assets
of 6 trillion yen, or approximately
US$55 billion under management.
We offer mainly individual term life
insurance products to small-to-medium
-sized enterprises that need to insure
against the loss of their key manage-
ment personnel. Japanese life insur-
ance companies have suffered from a
negative spread environment due to
the chronically low interest rates in
Japan. However, the profitability of
our main products is relatively high
for our industry, and we also have
conducted a strategic Asset Liability
Management study for our invest-
ments since the early 1990s. As such,
Daido is currently one of the most
profitable of the top ten largest
Japanese life insurance companies
and has the Standard & Poor’s finan-
cial strength of A+, reflecting its strong
financial position. On the first of April
2002, Daido became the first demutu-
alized and listed life insurance com-
pany in Japan. Back in 1999, we
formed a comprehensive alliance
with Taiyo Life to form a group
called T&D Life Group, and Taiyo
was demutualized and listed last
year. On the first of April 2004, a
joint holding company will be estab-
lished. The new company will be
listed on the Tokyo Stock Exchange.
It was in 1998 when we started
hedge fund investing. I have been
responsible for asset allocation at
Daido since 1990 and saw both the
decline of the stock market as well
as the fall in interest rates. Daido
continues to invest mainly in yen
fixed-income assets, with a relatively
small allocation to equity assets in
order to maintain stable profitability.
However, under this prolonged
severe investment environment, we
had to face the negative spread issue.
The financial condition of our firm
was still healthy at that time, thanks
to other profit gains that offset poor
investment performance. However, I
considered various ways to maintain
the same rate of return with lower
risk, or even to gain higher return
with lower risk, and concluded that
hedge fund and private equity invest-
ment would do this for us.
From early 1997, we started to study
hedge fund and private equity invest-
ing. The main questions we had at
that time were first, what are the
sources of excess returns, and sec-
ondly, whether or not these excess
returns can be expected to continue
going forward. After researching this
for a year and a half, we were fully
convinced of the benefits of having
alternative assets within our invest-
ment portfolio, and in June of 1998,
our subsidiary in New York, Daido
International, started to invest in
hedge funds. With little manager
selection capabilities in-house, we
retained a sub-adviser for the pro-
gram. One year later, our private
equity program was also initiated.
The goal of our hedge fund investing
program is to gain absolute return,
which has a low correlation with
traditional asset classes like equity
and fixed income. Another alternative
asset, private equity, generates a
J-curve shape return, and negative
performance is expected for the initial
several years. To mitigate this J-curve
effect, it is essential for us to have
stable, absolute investment returns
from hedge funds. Our target return
for hedge fund investing is the Fed
Funds Rate plus 4%.
We hired multiple gatekeepers to
manage separate accounts specifically
designed for Daido, and each gate-
keeper was given a slightly different
Alternative Investments Report Restructuring Distressed Companies in Japan 7
First, the fees are outrageously high.
It is just like the private equity world.
It is hard to justify them and it is
hard to justify how much money is
made by hedge fund managers. With
that said, if they can generate good
returns and you can be convinced
you are going to participate (it is not
just the managers participating), then
it is worthwhile doing. But identify-
ing those managers that truly have an
edge, the term that Narv used before,
is not an easy task. One of the books
I made students read for my class
this year is the book Money Ball.
It has a lot of great analogies for
investment business, one of which is
value investing. The book also high-
lights the difficulty of spotting talent
and also shows that talent is not
always what it appears at first glance.
Billy Bean, who is the main character
in the book, winds up becoming the
very successful manager of the
Oakland Athletics. He was a very
successful high school baseball player,
was recruited by everyone, and was
considered a “can’t miss.” I believe
he was the second draft pick that
year. However, once in professional
baseball, he was a bust. He looked
great on paper. He was tall, hand-
some, fast, could throw well, could
hit well, but he was not a winner.
The same challenge exists for
investors who are trying to evaluate
and find talented investment man-
agers, including hedge fund, private
equity, and long-only managers.
Evaluating talent is difficult. One
traditional approach, looking at
historical track records, turns out to
be pretty worthless for predicting
future returns from a manager.
Unfortunately, there is no science
that helps—you must look at a lot of
other intangibles. It is a tough, messy
process. Everyone obviously wants
to be in the good funds, but it is not
easy. There are a lot of academic
studies that go both ways, whether
or not it makes sense to invest in
hedge funds. Like private equity,
there is a wide deviation between
top quartile and bottom quartile
performers, and given the number
of funds that are starting, it is going
to be difficult picking the good man-
agers, increasingly difficult. Some
evidence exists that smaller funds
are better, so if you are looking to
expand a program, getting into a
larger number of smaller funds may
make sense.
In terms of transparency, we are
comfortable with risk exposure trans-
parency and, as I said, more organi-
zational transparency—what is going
on underneath the hood, having
access to the portfolio manager,
getting to talk to them, really under-
standing what they are doing. We do
not need position level transparency.
Benchmarking is another difficult
subject; we settled on the last alter-
native, which is a beta-adjusted
benchmark. In terms of fund of
funds, the good news is that there
is going to be a lot of business on
the public fund side. Public funds
will have a hard time staffing up
and investing in hedge funds the
right way without any help. I think
there will be a lot of opportunities
for fund of funds. The difficult thing
for the plan sponsor is the higher
fees associated with fund of funds.
Will the returns be sufficient to over-
whelm all of the fees, especially in
light of the low alpha world I antici-
pate? Is that extra level of fees going
to make it that much more difficult
for us, the plan sponsor?
In summary, I still think there are
good managers out there. It is worth-
while for us to invest in hedge funds
even if right now we are only 3 per-
cent of assets. If we can take it up to
5 percent of assets, it is meaningful
6 Center on Japanese Economy and Business Program on Alternative Investments
I do not think Japanese pension funds possess sufficient expertise in-house to conduct
hedge fund due diligence without the help of outside advisers.
—Kazuki Nakamoto
Kazuki Nakamoto
for the future development of a
healthy Japanese hedge fund investor
base. We understand, from our expe-
rience, that many long/short strategies
are biased toward long or short posi-
tions and therefore, careful fund
selection is essential. Otherwise, they
may become unexpectedly high risk
investments.
In conclusion, as I have discussed,
most hedge fund investing by
Japanese pension funds has been in
long/short strategies, unlike what
U.S. investors have done. It is only
relatively recently that Japanese
investors, including pension funds,
started investing in hedge funds and
therefore, not much strategic diversi-
fication has been achieved to date.
With the expected further penetration
of hedge fund investments, Japanese
investors will become aware of the
importance of diversification. That
being said, not many investors have
the wherewithal in-house to do man-
ager selection, so I believe commin-
gled hedge funds of funds products
will become increasingly popular.
Thank you very much.
MARK MASON
Thank you, Mr. Nakamoto. I would
next like to invite Professor Frank
Edwards, the Arthur F. Burns
Professor of Free and Competitive
Enterprise at Columbia Business
School, to comment on the two
presentations we have just heard.
Among his other academic research
interests, Professor Edwards has writ-
ten widely on aspects of the hedge
fund industry and brings to his work
advanced training in law as well as
finance.
FRANK EDWARDS
Arthur F. Burns Professor of Free and
Competitive Enterprise, Columbia
Business School
Thank you, Mark. Let me first begin
by complimenting the speakers. I
think they covered the ground pretty
well, so I do not have much to say
about what hedge funds are and
what they do. Also, while the func-
tion of the discussant is to stir up
some controversy, that may be
difficult here because the speakers
were careful not to overstate their
positions. I will, nevertheless, try to
provide a little controversy.
Most of the speakers say that, on
the one hand, hedge funds make
good returns—that they typically
earn a positive risk-adjusted return
(or alpha), but, on the other hand,
that there are lots of pitfalls for
hedge fund investors. There are, for
example, serious data problems, diffi-
culties in selecting fund managers,
and in monitoring the performance
of hedge funds and in deciding when
to fire poorly performing managers.
Also, there is the blow-up factor:
there are nonlinear hedge fund
strategies that may look pretty good
for a short time and then blow up
with large losses. But, overall, the
speakers conclude that investors
should invest in hedge funds.
That conclusion raises an important
conceptual issue, which none of the
speakers address. Why are hedge
funds able to earn positive alphas?
After all, most fund managers, like
mutual fund managers, typically are
unable to earn positive alphas. Why
can hedge funds do it? One answer is
that there exist market inefficiencies
that hedge funds can exploit. But
why can hedge funds, but not other
fund managers, exploit those ineffi-
ciencies? To complete this “inefficiency”
argument, therefore, you need two
things: market inefficiencies and a
reason why hedge funds are able
to exploit those inefficiencies while
most other fund managers cannot.
Alternative Investments Report Restructuring Distressed Companies in Japan 9
investment mandate. None of them is
allowed to invest in macro strategies,
since our investment purpose is to
gain a stable return. We also requested
them not to have CTA strategies,
because it is very hard for us to
understand them. Currently, six gate-
keepers manage separate accounts
for our firm, and we are also in one
commingled hedge fund of funds.
Under the current investment pro-
gram, our private equity investments
will be increased to 3.4% of the total
assets, which will be US$1.9 billion,
and the eventual allocation to hedge
funds will be 1.7%, or US$950 million.
For the last five years, our return
exceeded the Fed Funds Rate by 4.9%
with a standard deviation of 3.39%.
I am very pleased with this perform-
ance result because it achieved our
initial goal of gaining a higher invest-
ment return, with only a moderate
risk level.
Daido’s hedge fund portfolio strategy
is widely diversified. The return of
our hedge fund portfolio last year
alone was 10%, and this exceptionally
good performance was achieved
mainly as a result of the relatively
large allocation to distressed strategies.
Now, I would like to touch upon the
status of hedge fund investments by
Japanese investors in general. Not
much industry data exist that cover
the whole investor universe in Japan.
However, the Pension Fund Association
did a survey of its 1,580 corporate
pension fund members and found
that 1.3% of the total assets is allocated
to alternative investments. In value,
the allocation is 583 billion yen or
US$5.4 billion in total. Out of this,
more than 80% goes to hedge funds,
which is a much higher number
compared to Daido Life’s allocation
among alternative assets. There seem
to be two primary reasons for these
phenomena. First, private equity itself
is not well understood by Japanese
in general, and the market itself is
still at the developing stage. And,
second, hedge funds generate profits
within a relatively short period of
time. Most pension sponsors in Japan
have suffered from the decline of the
Japanese stock market as well as low
interest rates for the past ten-plus
years, and therefore they do not like
the J-curve, the negative early cash
flow pattern associated with private
equity investments.
A survey done by Goldman Sachs and
Russell Investment Group shows the
asset allocation to hedge funds by
49 leading pension fund sponsors
in Japan. While the sample is very
small, there is a clear trend of
increasing hedge fund allocations,
which is expected to continue.
The Pension Fund Association further
analyzed the 1,580 corporate pension
fund sponsors with an alternative
allocation and found that larger
sponsors tend to allocate more assets
to alternative investments. In fact,
if you look at corporate pension
funds with total assets of 200 billion
yen or more, which is US$1.8 billion
or more, approximately 93% of them
either already have alternative pro-
grams or are currently considering
adding one.
Let us examine some details of these
hedge fund investments. These data
include both hedge funds and private
equity investments, but as I have
already described, more than 80%
of the alternative allocations goes
to hedge funds. Roughly half of the
money went to individual hedge
funds. However, I would like to
point out that these individual fund
investments were not necessarily
made for the purpose of portfolio
diversification. A majority of individ-
ual hedge fund investments by
Japanese corporate pension funds
was mainly in long/short strategy.
We, at Daido, take a portfolio
approach to hedge fund investments
in order to achieve lower risk, and
we, therefore, diversify the strategies
of our underlying managers. Unlike
our firm, most Japanese pension
funds seem to have purchased indi-
vidual hedge fund products from
brokerage firms that claim they are
market-neutral funds. This is my
personal opinion, but I do not think
Japanese pension funds possess suffi-
cient expertise in-house to conduct
hedge fund due diligence without the
help of outside advisers. There are
some sophisticated pension funds,
but most invest in hedge funds with-
out considering the strategic asset
mix and risk-return profile of the
overall portfolio. As such, they tend
to concentrate on equity long/short
strategies simply because these prod-
ucts are marketed by brokerage
firms. Also, there seem to be many
pension funds that believe long/short
strategies have lower risk, since they
are market-neutral. I believe that this
could potentially be a serious issue
8 Center on Japanese Economy and Business Program on Alternative Investments
Hedge funds are largely unregulated, which leaves them free to exploit
market inefficiencies that other, more restricted, fund managers cannot.
—Frank Edwards
Frank Edwards
“blow-up” problem. In particular,
some hedge fund strategies yield
what are often called nonlinear pay-
offs, which basically means that you
may get pretty good looking returns
for two or three years or even longer,
but then suddenly you get a huge
loss. This has happened to many
hedge funds and even to some of the
most prominent hedge funds, like
Long Term Capital Management. What
is the appropriate strategy for manag-
ing this risk? And are you comfortable
with being exposed to this risk?
I appreciate the opportunity to be
here today and to be able to present
my views. Thank you.
MARK MASON
Our last panel speaker is Robert
Discolo, head of hedge fund invest-
ing at AIG Global Investment
Corporation.
ROBERT DISCOLO
Head of Hedge Fund Group, AIG Global
Investment Corporation
I come from a different viewpoint.
I agree—there are inefficiencies out
there. The problem is finding the
guys who can exploit the inefficien-
cies. That is the challenge in hedge
funds. One thing we did not hit
upon is: why are they so popular
now? I have been doing this for
fifteen years. I am commiserating
with one of my colleagues from
years and years ago. It has been
a tough business for a long time.
Somebody mentioned to me the
other day, “Bob, you’ve been great.
Returns are optimum, clients coming
in, you are an overnight success.”
I said, “Yeah, it took me 15 years to
be an overnight success!” Why so
popular now?
AIG’s philosophy is that hedge funds
are a talent pool, not an asset class,
and talent is not scaleable. We have
been investing in hedge funds for
over 20 years and the hardest single
thing to do is to find talent. And lately
with the explosion of hedge funds
it is like trying to find a needle in a
haystack, and the needles are getting
smaller and the haystacks are getting
larger.
We do believe that asset allocation is
important but not as important as in
traditional assets (where it accounts
for over 90% of returns). Our theory
is that alpha is 1/3 asset allocation
and 2/3 manager selection. At AIG
we look at over 500 funds a year and
invest in maybe 5 or 10 with the
process taking as long as a year. Our
belief is that you have to study the
manager, do detailed background
and reference checks, extensive inter-
viewing (including everyone in the
firm, even secretaries), and finally
do live trade examples with multiple
visits. It is an art and a science. But
the most important attribute of the
manager should be integrity. At AIG
we have a corporate culture of high
integrity and expect the same from
our managers, and we will never do
anything to besmirch the AIG name
as that is our most important asset.
This recipe has led us to successful
hedge fund investing for over 20 years.
My big concern is that too much
money is flowing into the business,
and there is a shortage of quality
managers. A lot of “dumb” money
is being thrown at less than stellar
managers giving hedge funds a bad
name. I fully believe that hedge
funds will be part of everyone’s
portfolio in the future, but we have
to be careful as to what we define
as hedge funds. There are very few
“true” hedge funds out there, and
many people are paying high fees
for beta, which anyone can get for
10 basis points from Vanguard.
Alternative Investments Report Restructuring Distressed Companies in Japan 11
But why do market inefficiencies
exist at all? A possible explanation is
that regulatory restrictions imposed
on other institutional investors (like
pension funds and mutual funds)
and other fund managers prevent
them from arbitraging away market
inefficiencies, providing unregulated
hedge funds with an opportunity to
exploit such inefficiencies. An exam-
ple may be legal restrictions on major
institutional investors that prevent
them from engaging in short selling
as part of an investment strategy. A
common characteristic of most hedge
fund strategies is that they involve
short selling to some degree. Another
possibility is that the structure of
hedge funds may allow them to cap-
ture a premium for illiquidity that
other fund managers cannot capture
because of regulations that restrict
their holdings of illiquid investments.
But these are just some possible
explanations. What we really would
like to have is some hard evidence
of market inefficiencies and why they
exist, which we do not have.
Assuming the existence of market
inefficiencies, then, why should
hedge fund managers be unique in
being able to exploit these inefficien-
cies? There are two possible explana-
tions. First, hedge funds are largely
unregulated, which leaves them free
to exploit market inefficiencies that
other, more restricted, fund managers
cannot. Second, hedge fund man-
agers may just be smarter—or more
skilled at exploiting these inefficien-
cies. But why should this be true?
The answer may be that they are
just paid much better than other fund
managers, and, as a consequence,
the most skilled fund managers natu-
rally gravitate to the hedge fund
industry. In particular, hedge fund
managers are typically paid a per-
centage of the fund’s earnings (often
10% to 20%), which can mean large
earnings for fund managers and a
better alignment of their interest with
those of hedge fund investors. Of
course, a potential drawback to this
compensation structure is that hedge
fund managers may have an incen-
tive to take more risk than investors
wish to take in order to increase their
own income. But notwithstanding
this caveat, the argument is that,
because they are unregulated, hedge
fund managers are better able to
exploit market inefficiencies and
have a greater incentive to seek out
profitable opportunities. I would
have liked to hear the panelists’ views
on these issues.
In addition, I would have liked to
hear the panelists discuss two other
issues. First, do they think that there
are market inefficiencies in Japan,
and, if so, what are these inefficien-
cies? Are the inefficiencies different
or greater in Japan than in the United
States? Do hedge funds pursue differ-
ent investment strategies in Japan
than in the United States? Second,
following up on the panelists’ discus-
sion of investor pitfalls, what kind of
characteristics should we look for in
a hedge fund manager? Alternatively,
why should a pension fund manager
(or anyone else) have the skills nec-
essary to be able to select a good
hedge fund manager? What are the
skills that a pension fund manager
needs to have to be able to do this
successfully on a consistent basis?
And why should we expect pension
funds to hire managers who have
the requisite skills? Pension fund
managers are not typically paid in a
way that aligns their incentives with
those of their beneficiaries. It is a bit
puzzling to me, therefore, why we
should expect pension funds to be
able to implement a successful hedge
fund investment program.
Finally, I would have liked the
panelists to address what I call the
10 Center on Japanese Economy and Business Program on Alternative Investments
Hedge funds are a talent pool, not an asset class, and talent is not scalable.
—Robert Discolo
Robert Discolo
Top: Larry Glosten introduces the keynote
speaker. Bottom: David Russ, keynote speaker.
EDITOR
Dr. Yoko Mochizuki
Program Officer
Center on Japanese Economy
and Business
ASSOCIATE EDITOR
Emi Nakano
Program Consultant
Center on Japanese Economy
and Business
PHOTOGRAPHY
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